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US post-crisis recovery now complete?

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A week of important meetings – and yet our eyes were not on Singapore, but firmly on the Fed.  The economic growth picture in the US just seems to get better and better, making economists and market participants even more nervous of when the turn (recession) will come, and how painful it will be.

At a glance, the US economy appears to be in a perfect sweet spot: capital expenditure is increasing; consumer confidence is high (note the retail sales numbers this week); inflation is under control and forecast to stay reasonably low.  It is difficult to envision what exactly will catch us out.  However, turn to the employment figures and the cracks start to show.  The labour market is extremely tight, with May’s unemployment rate of 3.8% representing an 18 year low and – crucially – the second month in a row for which there have been more job openings than people registered as looking for work. This means that ‘quits’ should increase, and wage growth will not be far behind.  Given its current low level, particularly when compared to previous late cycle statistics, this could lead to a significant shock.  As companies look ahead to 2019, labour costs are forecast to be in their top three concerns.

The Fed, of course, raised rates by the predicted 0.25% at the meeting and added a fourth dot to their projection for 2018; indicating no change to the total number of rate rises but altering the distribution of when they will occur between now and 2020.  Market expectations are under-shooting the Fed’s own “Dots” by as much as 0.50% through 2019 and 0.75% to the end of 2020.

The press conference contained a change in language used to reference growth – now ‘solid’ rather than ‘moderate’ – and a small uptick in growth forecasts to 2.8% for 2018 (which looks likely to be beaten).  More telling was the absence of a paragraph contained in previous statements, which had stated that ‘the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the long run’.  It is difficult to interpret what this omission means, but my guess is that the normalisation of monetary policy might need to pivot towards a more hawkish position in order to reign in growth (and higher inflation) should the economy continue to demonstrate the strength it has in recent months. 

The Fed has, in my view, done a remarkable job of guiding the markets through their normalisation activity, and the use of the ‘dot plot’ to consistently provide forward guidance has definitely helped their credibility.  However, I would question whether such transparency has the same benefits when the monetary cycle has to turn the other way.  If the dot plot starts to show an uptick in future rates, would the market take that to mean the Fed was predicting a slowdown or recession?  And would this then become a self-fulfilling prophecy? With this in mind, we may have the reason for Powell announcing that from January next year the Fed will hold a press conference after every meeting, rather than just at the end of each quarter). It will give the Fed the chance to make more frequent changes (so far, since 2011 all movements in rates have happened at meetings which were followed by a press statement) and react to the economic data flow more nimbly; at the same time weaning the market off the forward guidance on which it has become so reliant.

Emerging markets, and their currencies in particular have certainly been the ones who have suffered in the Fed’s successful normalisation and the strengthening USD – basically bad news for all risk assets.  Spillover effects from US monetary policy are nothing new, but on this occasion the threat of a bull run by the USD has prompted the Governor of the Reserve Bank of India, Urjit Patel, to take the deeply unusual step of calling on the Fed to slow down.  His argument is that when the Fed started the process of shrinking its balance sheet, President Trump’s tax cuts were not yet on the horizon.  Now that the scale of the US fiscal deficit is known (having already absorbed foreign savings, it will now require bond issuance to the tune of $1.8 trillion), the Fed should adjust its balance sheet management to limit the effects of lower USD liquidity.  The mechanics of this argument are correct - but it is hard not to point out that the Fed’s role is to achieve its domestic objectives, not to prioritise emerging market pain relief.

We would expect some calm to return to emerging markets when forward-looking markets have fully reflected the change in US policy – fiscal and monetary.  And before last week’s Fed meeting it was conceivable that we were getting close to that point.  However, recent hawkishness this week suggests there might be more pain to come.

There is also a much more important question to ask. It is obviously tempting to call the end of the post-crisis recovery and close the door on an extremely difficult period. But the real question is not whether the last crisis is over – it is how the next one will begin. For those of us planning to stay in the markets, just as useful than the Fed’s pronouncements might be the words of Yogi Berra:  “it ain’t over until it’s over”.

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